Why It Suddenly Pays to Own the Natural Gas ETF

By Brendan Conway

For years, fund experts warned buy-and-hold investors against owning the United States Natural Fund (UNG), whose returns are tied to the futures market — not to spot gas prices.

But for a few months now, this exchange-traded fund has been working for people other than the fast traders who are its primary clientele. The fund is ahead by about 21% on the year — that’s only a few percentage points behind spot gas’ 25% rise.

What changed? The futures market that drives this fund has, for the moment, gotten more benign for investors with a longer view. The change is that the phenomenon of “contango,” meaning the upward-sloping curve of gas futures contracts that usually acts as a headwind against commodity-futures ETFs over longer periods, has flattened out. This flattening means it costs less to shift from one set of futures to the next. The factor causes UNG’s performance to resemble more closely what’s happening in spot gas prices. Read my print Barron’s column for a fuller explanation.

It wasn’t that way until pretty recently. Last year, amid a steep contango in the futures market, the ETF fell 27%, even as the spot gas price advanced 15%.

Things could shift back with little notice. But for months, they’ve been favorable.

I touched base on the subject with John Hyland of United States Commodity Funds via email last week. Here’s part of what he had to say. Short version: While less contango can make things more palatable for investors with longer time horizons, there’s still no hard-and-fast rule for when to own the gas ETF — just your judgment of the futures market. And “buy and hold” is still a tough proposition if we’re talking years instead of months.

From Hyland:

With 20-20 hindsight, people “know” that buying UNG over the long term was a bad idea. Of course with perfect hindsight, people “know” that buying [US Brent Oil Fund (BNO) long-term was a brilliant idea. Both happen to be single commodity futures owning ETFs that have identical portfolio construction except for which commodity they own.

Unfortunately, many or most investors are always looking for simple answers, or at least simple rule of thumbs, when they are investing. Many of those investment “rules” turn out to be not be well grounded. The “Never invest in a single commodity futures based ETF except over short time periods” is one of them.

As best we can tell, most people DO use single commodity futures based ETFs mostly for short and medium term trading. Partly this may be a reflection of their trading approach. After all, although many investors might have a view on where oil, gasoline, or copper is going over the next few weeks or months, or are just looking to hedge the event risk of problems with Iran/Syria/Libya/fill-in-your-favorite-flashpoint-here over the next quarter, I would guess far fewer would be willing to take a position on where they will be in 18 months.

However, as the rule of thumb suggests, it is partly because IF a particularly commodity is currently in contango, holding for longer periods of time can lead to the situation where even if you are right about the direction of the spot price, you can have a losing position due to the erosion of contango. If you are in the commodity for shorter periods of time, contango just ends up being a smaller part of the equation. Of course if you are wrong about the move of the spot price than contango just increases the losses on your position. The natural gas spot price is down 47% since UNG launched in 2007. So almost any approach to investing in natural gas over the last 6 years, except for short-term trading, has tended to not work out regardless of how an ETF portfolio gets constructed. We do have a second natural gas ETF, [United States 12 Month Natural Gas Fund (UNL),] that has a different portfolio than UNG which works to reduce the negative effect of contango, and it is still down a bunch (you know how a “rising tide l[i]fts all boats”? Well, guess what a falling tide does?).

However, from the above you cannot just assume that because UNG has underperformed the spot price of natural gas over the years due to contango, that it is universally true that using any single commodity futures based ETFs for anything less than a short-term trade is a bad idea. At any given time some part of the commodity universe will be in backwardation and that changes everything. For example, over the last 5 years or so the spot price of gasoline is up about 6%, but the NAV of the US Gasoline Fund (“UGA“), is up 13% due to the fact that gasoline has spent a fair amount of time in backwardation. A more extreme example is Brent crude oil. Over just under three years the spot price of Brent is up 43%, but the US Brent Oil Fund (“BNO”), is up 57% since inception in mid-2010. Once again because Brent has spent a large portion of that time in backwardation.

The reality is that among major commodities over the last few years, Brent crude oil and natural gas happen to represent the two extreme ends of the spectrum. You could argue that trying to draw up investment rules based on the two extreme outcomes is not necessarily a great way to plan ahead. It is nice to know going into any investment area how good it can be, and how bad it can be, but you should not get carried away with the results of just two commodities out of a universe of maybe 20-30 commodities.

So the real rule of thumb might be a “If the commodity today is in contango, you likely will invest with a shorter time horizon, but if the commodity is in backwardation, you might invest with a longer horizon”. Still, I would guess that most usage of single commodity ETFs revolves around more tactical trading and not any sort of buy-and-hold strategy.

Add a Comment

We welcome thoughtful comments from readers. Please comply with our guidelines. Our blogs do not require the use of your real name.

Comment

There are 2 comments

APRIL 18, 2013 8:26 P.M.

KinybokeKinna wrote:

 LIVESTRONG is a registered trademark of the LIVESTRONG Foundation. Additionally, we usually do notExcellent job!I got what you mean , appreciate it for putting up.Woh I am thankful to find this website through google.mentioned what is that for and that i said it is to keep in mind stuff.
 fleece-lined, form-fitting fashion that the Australian pilots favored. But the organization added aThis is a excellent story. Thanks!I really appreciate this post.I gotta bookmark this website it seems very useful very helpful
 I think the character on this team will go within a good path." Burkhead stated a number ofare going to adhere to them," Burkhead mentioned..hello there and thank you for your information ?I certainly picked up anything new from right here. But wanna tell that this is very beneficial , Thanks for taking your time to write this.

DECEMBER 4, 2013 4:06 P.M.

Harlan Cervantez wrote:

My heart broke when they zoomed in on Nando's face at the beginning on the match. He looked so sad. I honestly believed he'd come in after the 70th minute or so. I'd adore for him to see some action in Munich.

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.